A court ruling that threatens the private equity industry in the US

A legal case that has received almost no attention in the mass media could potentially seriously damage the private equity business in the US. In Sun Capital vs. New England Teamsters and Trucking Industry Pension Fund, the First Circuit Court of Appeals ruled that a fund managed by Sun Capital was engaged in a "trade or business" rather than as a passive investor with respect to one of its portfolio companies.

The private equity industry has received considerable attention from many politicians and the media because the offshore funds' incentive fees (carried interest) have been taxed as capital gains rather than ordinary income. While fund managers would hate if these fees were to be taxed as ordinary income, most are prepared for this change - in fact many believe it's only a matter of time. The issue of the "trade or business" treatment on the other hand is far more damaging to the industry than the carried interest tax treatment. And virtually nobody is prepared for how it may play out.

There are a number of reasons many investors have to come into private equity funds through offshore vehicles (such as Cayman Islands based funds for example). If you are the Ontario Teachers Pension or Sunsuper (an Australian pension fund) for example, the last thing you want is to have to file taxes in the US. The same applies to sovereign funds such as China Investment Corp. Such entities usually invest in private US companies via these offshore funds. Some foreign investors already pay taxes in their domestic jurisdictions and do not wish to be double-taxed. Many US tax-exempt entities such as corporate pensions often invest via offshore funds as well.

Bloomberg: - If courts or regulators apply that logic to the U.S. tax code, the changes could jeopardize the structure of the industry by altering some core benefits of private equity. Those are low-taxed carried interest for fund managers, tax-free income for universities and an exemption from U.S. taxes for foreign investors.

“The size of the risk is huge,” said Steve Rosenthal, a visiting fellow at the Tax Policy Center in Washington. “The likelihood of the IRS pursuing this is unclear.

The "trade or business" treatment could force these offshore funds to file taxes in the US. And many foreign pensions would rather forgo investing in the US at all than being forced to deal with the IRS. The same applies to many tax-exempt investors in the US. That means the flow of foreign capital now coming into the US to finance private corporations, will slow dramatically if these funds are ruled by the IRS to be engaged in a "trade or business". Many private equity-backed firms grow quickly and create more jobs than public firms. And a slowdown in job creation due to weaker inflows of foreign capital as well as domestic tax-exempt capital is the last thing the US needs right now.

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